China is growing fond of currency baskets. After the International Monetary Fund (IMF) added the yuan to its reserve currency basket, China decided it wanted to use a basket to track the exchange rate of its currency, rather than just the U.S. dollar.
This opens the door to further yuan depreciation, not to increase growth, but to prevent mass unemployment.
China has tracked the movement of the dollar until 2005, when the People’s Bank of China (PBOC) started to adopt a softer peg, but still kept the exchange rate under close control. This summer, the PBOC almost abandoned the peg and devalued the yuan, much to the surprise of the market. Since then it has gradually managed the decline against the U.S. dollar, and that’s where the new basket comes in.
Like the IMF’s special drawing rights (SDR) basket, the trade-weighted index of the PBOC is an empty basket. It just provides a reference to the value of the Chinese yuan compared to the currencies of its most important trading partners.
Under normal circumstances, this is hardly worth mentioning. The U.S. dollar index or DXY is exactly the same and nobody ever thought it strange.
These baskets help policymakers gauge whether their currency is over or undervalued against its most important trading partners. In the case of the Chinese currency, for example, the yuan isn’t much overvalued compared to the U.S. dollar, but more so against other currencies.
The Chinese Foreign Exchange Trade System (CFETS), which is part of the PBOC and calculates the basket, said as much in its original press release: “Therefore, the renminbi is a relatively strong currency among the major international currencies.”
Mark Williams, chief economist of Capital Economics says: “Because of the link to the strengthening dollar, the renminbi has appreciated significantly in trade-weighted terms. Yet any sustained weakness in the renminbi relative to the dollar tends to be interpreted as ‘devaluation’ and trigger market concerns.”
Yes, the mini-devaluation in August did not even reach 3 percent and yet financial markets across the world went haywire at the end of the month.
Since the IMF added the renminbi to its SDR basket, the PBOC let the yuan drop for seven consecutive days as of Dec. 15, the biggest devaluation on record, again very much under the scrutiny of the media and financial markets.
The yuan dropped another 1 percent against the dollar since Nov. 16, the day China was all but certain it would get the approval for the SDR.
If China wants to significantly devalue against all of its major trading partners, it will have to devalue even more against the dollar, which only makes up 26 percent of the basket and has been rising against other big currencies like the euro or the yen, taking the yuan with it on its rise.
Because “the authorities have increasingly drawn public focus to the renminbi’s performance on a trade-weighted-index basis rather than simply against the U.S. dollar, it reinforces the likelihood of moderate depreciation versus the U.S. dollar, should the broad U.S. dollar continue to strengthen,” Goldman Sachs writes in a note.
In other words, according to Goldman Sachs, it gives Beijing an excuse to say, “Our currency is very overvalued and we need to depreciate, especially against the U.S. dollar.”
Analysts at Macquarie think the yuan could weaken as much as 5 percent against the dollar in 2016. Most analysts, however, believe the yuan is about 15 to 20 percent overvalued on a trade-weighted basis. With the new excuse in the form of the basket, this makes a larger devaluation against the dollar more likely.
Why They Are Doing It
Why is China going to great lengths to justify devaluing its currency not just against the U.S. dollar but also against the currencies of its major trading partners?
Many analysts believe it’s because China wants to boost growth through exports. This, however, is unlikely.
“They were at the peak which was just a few years ago. Their net exports were 8 percent of GDP. Now it’s just a couple of percent of GDP,” says Richard Vague, author of “The Next Economic Disaster.” Net exports contribute almost nothing to GDP growth.
According to World Bank data, the share of total exports of GDP has been declining to 22.6 percent in 2014 from 25.5 percent in 2011. So what is all the fuss about?
Trade still significantly contributes to employment in China.
“China is so much about jobs as opposed to profits, it is very important for the government to maintain jobs,” says billionaire investor Wilbur Ross of WL Ross & Co.
It’s especially important to maintain jobs when the economy is slowing down and labor costs are becoming less competitive. In this respect, 2015 was a complete disaster:
“From January to November 2015, China’s exports of labor-intensive products contracted by 6 percent year on year while exports of hi-tech products were flat. China’s processing exports, which are built on low labor costs, fell 10 percent, while China’s ordinary exports increased by 2 percent,” investment bank Macquarie writes in a note.
According to a report by the Bundesbank, employment from exports was still 80 million people in 2009 (10.2 percent of total employment), down from 99 million in 2007 (12.9 percent of total employment).
Although the report was released in 2014, the data from 2009 is a bit dated and also reflects the fall in employment because of the financial crisis.
According to a report by George Washington University, more than 20 million people lost their jobs in Chinese coastal areas after the financial crisis—the main reason China started its infrastructure and investment program, which provided work but also produced massive overcapacity.
Exports picked up shortly after for a couple of years but have been declining for the last five months in 2015.
Because investment spending is also slowing down, and the consumer so far hasn’t shown up to the rescue, Chinese policymakers have good grounds to be nervous.
“China is different from Russia. In Russia, when you have depressions, workers get drunk. But in China they riot and they hate the Communist Party who are mostly thugs and crooks,” says Woody Brock of Strategic Economic Decisions Inc.
To wit, according to the China Labor Bulletin, strikes and protests in 2015 are breaking all records.
This is why the regime is stimulating on all fronts: the stock market, local governments, investment spending, and now exports. But will it work?
Gordon Chang, author of “The Coming Collapse of China,” doesn’t think so: “The Communist Party’s primary basis of legitimacy has been that continual delivery of prosperity. … So you look at all the things they’ve been trying to do and in the past they’ve created growth with these techniques. They can’t do it now and that really means they are in jeopardy; you’re going to have more and more protests.”
